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Monday, November 05, 2007

Electricity Deregulation Explained (1 of 3)

This is the first in a series of three blog entries that attempts to explain electricity markets: why regulation was necessary at one time, why it may not be now, and what it means to be an electricity consumer in the wake of deregulation. Part 1 provides the background. Part 2 explains how deregulation works from a consumer’s perspective. Part 3 describes the choices available to deregulated market participants and the near-term outlook for deregulation at the time of this writing (November 2007).

BACKGROUND

Most people have heard about electricity deregulation, but very few understand what it means. In brief, deregulation began as an attempt to restore fairness to electricity markets that have, over the last couple of decades, outgrown the 1930s business model upon which they are based. In practice, deregulation has been a fitful process for consumers, utilities, and lawmakers that are caught in the middle. Consumers have come to expect the market for electricity (or “power”) to be simple, fair, and offer low prices. Unfortunately, consumers can only obtain any two of those virtues, usually at the expense of the third. The good news is that consumers in deregulated power markets can choose which two virtues they wish to optimize. In other words, access to electricity can be: • simple & cheap, while compromising fairness;• simple and fair, which generally precludes cheap prices; or • cheap & fair, which is not a simple market for its participants.

Regulation is the legacy of utility business models from years past, which in turn reflected the technology of the times. Prior to 1935, electric companies could and did clutter cities and streets with competing sets of distribution wires and ancillary equipment. Federal legislation passed that year would enable the utility business model as a regionalized monopoly, so that only one utility company’s infrastructure served a defined geographic area. In this format, a utility offered the simplicity of one supplier with one price schedule. In return for a monopoly franchise, utility businesses were closely regulated by state-chartered public utility commissions. Commissioners were tasked with representing the consumers’ interest by ensuring that the rate for electricity covered the utility’s operating costs while providing a fair return to the utility’s investors—and no more. From the 1930s through deregulation’s take-off in the 1990s, electric utility companies provided steady if unspectacular financial returns. Large institutions have come to rely on utility-issued equity as a key part of their investment strategies.

By the 1990s, a number of forces began to challenge the classic electric utility business model. Perhaps the most important forces were (1) the escalating cost of fuels needed to generate power; (2) the growing variety of power generation technologies; (3) and the increased willingness of large-quantity consumers to relocate their facilities in search of better electric rates, or to simply generate their own power onsite. The economic tension created by these forces demanded resolution.

Immediately, questions of fairness come to mind. Why should the large consumer be forced to accept the local utility’s electric rate when it can buy cheaper power in another location? Why should smaller customers subsidize the cost of serving larger ones? Why should the steady investment returns to utility investors be interrupted? If these returns are interrupted, utilities will find it a lot harder to attract investors. The only cure for that is to raise the rate of return on utility investments. In other words, the cost of capital for utilities would escalate, which in turn raises the cost to produce (and the price to buy) electricity. As electricity prices go up, common citizens begin to petition lawmakers for protection. Average citizens (and lawmakers) do not understand the cost-price relationship for producing electricity; many people assume that electricity prices can be determined by the stroke of a pen, regardless of its actual cost of production. Does it not seem unfair to have elected officials decide the price of electricity? Exactly how are they supposed to do that?

The solution to this dilemma is to open electricity markets to competition. Power generation can be accomplished by competing suppliers. Meanwhile, the local distribution and service portions of electricity provision remain the same—it’s still not practical to have competing sets of wires lining the street. By allowing competition among generators, big consumers can get access to lower electricity prices without relocating. But if you open the market to the big consumers, you must open it for all the small businesses and homes, too.